Even for a company with specialist knowledge about gaining altitude quickly, Rolls-Royce (LSE: RR) has had an incredible 12 months on the stock market. Over the period, the Rolle-Royce share price has soared 147%.
It now stands at an all-time high.
That marks an incredible change of circumstances from four years ago. Then, the company was shoring up its liquidity, massively diluting existing shareholders to raise cash. It cut its dividend (that it now plans to bring back).
So is the past year’s performance the sort of frothy rise that precedes a fall? Or might the Rolls-Royce share price, having already soared from pennies to almost a fiver, still be a bargain?
Why this might be a bargain
Counterintuitive though it might seem given that stunning recent performance, I think the shares may still be a bargain. That is because I am a long-term investor.
The current Rolls-Royce share price-to-earnings (P/E) ratio is 18. That is not cheap but it is not necessarily expensive for a blue-chip FTSE 100 firm. US rival General Electric is more than twice as costly, with a P/E ratio of 40.
Demand for aircraft engines and servicing is robust. Indeed, order books at the main manufacturers including Rolls stretch years into the future. Barriers to entry are high and quality is critical, giving the makers’ pricing power. Rolls-Royce has an installed base of thousands of engines, underpinning strong long-term prospects for its servicing business.
If those factors continue – and they may well – the outlook for engine makers looks promising.
Rolls has taken a more commercially aggressive approach over the past year or so and has set itself ambitious financial targets for the medium term. If it hits them, earnings per share could jump, meaning the prospective P/E ratio is significantly below 18. And in fact, could be a bargain.
But it could also be a peak
On the other hand, I see a risk that the Rolls-Royce share price has reached maximum altitude, perhaps not to be reached again for a long time.
We know from repeated past experiences that civil aviation demand can suddenly fall due to unexpected events outside airlines’ control, from war to government travel restrictions.
While Rolls’ nuclear power and military aviation businesses give it some cushioning, civil aviation remains core to its success. If demand falls unexpectedly, that will likely be bad news for Rolls-Royce’s revenues, profits – and share price.
On top of that, I think the current share price reflects City optimism about the company meeting its ambitious targets. With a long history of mixed performance, it remains to be seen whether Rolls can do that and maintain the performance. If it seems too profitable, airlines may drive harder bargains on pricing, potentially eating into sales volumes and profits.
At the current price, the risk profile sits uncomfortably with me. So while even the current Rolls-Royce share price could yet turn out to be a long-term bargain, depending on how the business does, I have no plans to buy just now.
